Welfare, Stabilization, or Growth: A Comparison of Fiscal Policy Objectives

Abstract

This paper investigates a variety of objectives that are commonly used to motivate government fiscal action. These include welfare maximization, stabilization and growth maximization. The policies are compared on the basis of their implications for welfare, volatility and growth. We show that stabilization policies can produce welfare levels that are nearly identical to those of welfare maximization policies and that both welfare maximization and stabilization policies yield large welfare gains and modest growth losses relative to growth maximization policies. We also show that there are side issues to stabilization polices. In particular: 1) It is not possible to stabilize all macroeconomic variables simultaneously, even when the number of policy instruments is equal to the number of shocks; 2) stabilizing a particular variable requires increased volatility of some other variable; 3) stabilization requires some flexibility regarding the government's budget constraint; and 4) stabilization requires the government to respond in a precise and immediate way to exogenous shocks which hit the economy.

JEL Classification: E32, E62, O41